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The Monetary System
IMBA Macroeconomics II
Lecturer: Jack Wu
Money

Money is the set of assets in an economy
that people regularly use to buy goods and
services from other people.
Functions of Money

Money has three functions in the economy:



Medium of exchange
Unit of account
Store of value
Liquidity

Liquidity

Liquidity is the ease with which an asset can be
converted into the economy’s medium of
exchange.
Kinds of Money

Commodity money takes the form of a
commodity with intrinsic value.


Examples: Gold, silver, cigarettes.
Fiat money is used as money because of
government decree.


It does not have intrinsic value.
Examples: Coins, currency, check deposits.
Money in the Economy


Currency is the paper bills and coins in the
hands of the public.
Demand deposits are balances in bank
accounts that depositors can access on
demand by writing a check.
Money Supply


M1
_ M1A
_ M1B
M2
Federal Reserve

The Federal Reserve (Fed) serves as the
nation’s central bank.


It is designed to oversee the banking system.
It regulates the quantity of money in the
economy.
Federal Open Market Committee

The Federal Open Market Committee (FOMC)


Serves as the main policy-making organ of the
Federal Reserve System.
Meets approximately every six weeks to review
the economy.
Monetary Policy

Monetary policy is conducted by the Federal
Open Market Committee.


Monetary policy is the setting of the money
supply by policymakers in the central bank
The money supply refers to the quantity of
money available in the economy.
Open-Market Operations

Open-Market Operations


The money supply is the quantity of money
available in the economy.
The primary way in which the Fed changes the
money supply is through open-market operations.

The Fed purchases and sells U.S. government bonds.
Open-Market Operations:
continued

Open-Market Operations


To increase the money supply, the Fed buys
government bonds from the public.
To decrease the money supply, the Fed sells
government bonds to the public.
Banks and Money Supply




Banks can influence the quantity of demand deposits
in the economy and the money supply.
Reserves are deposits that banks have received but
have not loaned out.
In a fractional-reserve banking system, banks hold a
fraction of the money deposited as reserves and lend
out the rest.
Reserve Ratio

The reserve ratio is the fraction of deposits that banks
hold as reserves.
Money Creation


When a bank makes a loan from its reserves, the money
supply increases.
The money supply is affected by the amount deposited
in banks and the amount that banks loan.



Deposits into a bank are recorded as both assets and liabilities.
The fraction of total deposits that a bank has to keep as
reserves is called the reserve ratio.
Loans become an asset to the bank.
T-Account

T-Account shows a bank that…




accepts deposits,
keeps a portion
as reserves,
and lends out
the rest.
It assumes a
reserve ratio
of 10%.
T-Account: First National Bank
First National Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
$90.00
Total Assets
$100.00
Total Liabilities
$100.00
Money Creation: continued



When one bank loans money, that money is
generally deposited into another bank.
This creates more deposits and more
reserves to be lent out.
When a bank makes a loan from its reserves,
the money supply increases.
Money Multiplier


How much money is eventually created in
this economy?
The money multiplier is the amount of
money the banking system generates with
each dollar of reserves.
The Money Multiplier
First National Bank
Assets
Liabilities
Reserves
$10.00
Deposits
$100.00
Loans
Second National Bank
Assets
Reserves
$9.00
Liabilities
Deposits
$90.00
Loans
$90.00
Total Assets
Total Liabilities
$100.00
$100.00
$81.00
Total Assets
$90.00
Total Liabilities
$90.00
Money Supply = $190.00!
Money Multiplier:continued



The money multiplier is the reciprocal of the
reserve ratio:
M = 1/R
With a reserve requirement, R = 20% or 1/5,
The multiplier is 5.
Tools of Money Control

The Fed has three tools in its monetary
toolbox:



Open-market operations
Changing the reserve requirement
Changing the discount rate
Open-Market Operations

Open-Market Operations

The Fed conducts open-market operations when
it buys government bonds from or sells
government bonds to the public:


When the Fed buys government bonds, the money
supply increases.
The money supply decreases when the Fed sells
government bonds.
Reserve Requirements

Reserve Requirements


The Fed also influences the money supply with
reserve requirements.
Reserve requirements are regulations on the
minimum amount of reserves that banks must
hold against deposits.
Change the Reserve
Requirement

Changing the Reserve Requirement

The reserve requirement is the amount (%) of a
bank’s total reserves that may not be loaned out.


Increasing the reserve requirement decreases the
money supply.
Decreasing the reserve requirement increases the
money supply.
Change Discount Rate

Changing the Discount Rate

The discount rate is the interest rate the Fed
charges banks for loans.


Increasing the discount rate decreases the money
supply.
Decreasing the discount rate increases the money
supply.
Problems in Controlling Money
Supply


The Fed’s control of the money supply is not precise.
The Fed must wrestle with two problems that arise due
to fractional-reserve banking.


The Fed does not control the amount of money that
households choose to hold as deposits in banks.
The Fed does not control the amount of money that
bankers choose to lend.
Money Supply

The money supply is a policy variable that is
controlled by the Fed.

Through instruments such as open-market
operations, the Fed directly controls the quantity
of money supplied.
Money Demand


Money demand has several determinants,
including interest rates and the average level
of prices in the economy
People hold money because it is the medium
of exchange.

The amount of money people choose to hold
depends on the prices of goods and services.
Value of
Money, 1/P
(High)
Price
Level, P
Money supply
1
1
3
1.33
/4
12
/
Equilibrium
value of
money
(Low)
A
(Low)
2
Equilibrium
price level
14
4
/
Money
demand
0
Quantity fixed
by the Fed
Quantity of
Money
(High)
Copyright © 2004 South-Western
Value of
Money, 1/P
(High)
MS1
MS2
1
1
1. An increase
in the money
supply . . .
3
2. . . . decreases
the value of
money . . .
Price
Level, P
/4
12
/
1.33
A
2
B
14
/
(Low)
3. . . . and
increases
the price
level.
4
Money
demand
(High)
(Low)
0
M1
M2
Quantity of
Money
Copyright © 2004 South-Western
Quantity Theory of Money

The Quantity Theory of Money

How the price level is determined and why it
might change over time is called the quantity
theory of money.


The quantity of money available in the economy
determines the value of money.
The primary cause of inflation is the growth in the
quantity of money.
Velocity of Money

The velocity of money refers to the speed at which the
typical dollar bill travels around the economy from
wallet to wallet.
V = (P  Y)/M

Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
Quantity Equation


Rewriting the equation gives the quantity
equation:
MV=PY
The quantity equation relates the quantity of
money (M) to the nominal value of output
(P  Y).
Quantity Equation

The quantity equation shows that an
increase in the quantity of money in an
economy must be reflected in one of three
other variables:



the price level must rise,
the quantity of output must rise, or
the velocity of money must fall.
Inflation Tax



When the government raises revenue by
printing money, it is said to levy an inflation
tax.
An inflation tax is like a tax on everyone who
holds money.
The inflation ends when the government
institutes fiscal reforms such as cuts in
government spending.